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Saturday, May 24, 2014

Interesting map below of state by state unemployment rates in the United States. This graphic helps visualize a theme reviewed here many times over the past year, which is the center of the country will continue to grow at a faster rate and foster a more accommodating environment for businesses in the decade ahead.

One of the biggest questions at the end of 2013 was how the Treasury market would react to the reduction of bond buying that would result from the Federal Reserve’s tapering campaign. If the Fed were to hold course to its stated intentions, its $45 billion monthly purchases of Treasury bonds would be completely wound down by the 4th quarter of 2014. Given that those purchases represented a very large portion of Treasury bond issuance at that time, it was widely assumed by many, me in particular, that the sidelining of such huge demand would push down the price of Treasury bonds. Without the Fed’s bid, interest rates would have to rise.

But almost five months later, yields on the 10-year Treasury bond are 50 basis points lower than they were at the end of 2013, despite the fact that the Fed has officially trimmed its monthly purchases in half. Apparently, plenty of other buyers were prepared to fill the void. Many have concluded that Uncle Sam doesn’t need the Fed after all. But a close look at international activity in the Treasury market reveals some odd patterns that should be explained.

Over the last six months Belgium has started to behave eccentrically, even by Belgian standards. No, the small country of 11 million has not decided to stop making chocolate or waffles. It has decided to increase its buying of U.S. Treasury bonds…in a very big way. According to latest U.S. Treasury Department data, since August of 2013 entities in Belgium have purchased and held a stunning $215 billion of U.S. Treasuries. This figure is equivalent to about half the country’s annual GDP, and equates to almost $20,000 for every living Belgian. Prior to that time, Belgium had held its cache fairly steady at around $170-$190 billion. But by March, that total had increased by almost 130% (to $381 billion) in just seven months. The purchases represented 61% of the total increase in foreign holdings of U.S. Treasuries over that time frame. Given the fact that Belgium, as of last September, had less than 3% of the Treasury bonds held by foreign sources, this is strange behavior indeed.

Of course exactly who is buying those bonds remains a mystery. It’s only known for sure that a Belgium-based clearing house called Euroclear is “likely responsible” for holding the $200 plus billion in Treasuries. It’s amazing in this day and age when every e-mail and phone call is scrubbed for security content that hundreds of billions of dollars could move across borders without anyone really knowing what is going on. Of course this is likely only possible if official sources themselves are the transacting parties.

What is clear is that this is not likely the government of Belgium, or private Belgian capital, that is doing the buying. The numbers are just too large. This is particularly true in the First Quarter of 2014 when the buying averaged a stunning $41.5 billion per month (January was the biggest month with $54 billion). In all likelihood, the only European buyer with a wallet that big would be the European Central Bank (ECB) itself. But why would the ECB buy when the Federal Reserve was supposed to be tapering?

It is widely recognized that as the flow of capital increases exponentially across borders, and financial systems become more globally integrated, international central bank cooperation has increased. This is especially true between the Federal Reserve and the European Central Bank (ECB) which have closely coordinated policy to deal with the Great Recession of 2008 and the European Sovereign Debt Crisis of 2011. Exactly how, where, and why these banks have worked together is a little harder to imagine.

Back in late 2011, when the sovereign debt crisis of Greece, Spain, Italy and Portugal threatened to fracture the European Union and take down the euro currency, the Wall Street Journal reported the Federal Reserve was engaging at that time in a “covert bailout” of European banks. Using what was known as a “temporary U.S. dollar liquidity swap arrangement,” the Fed provided billions in funds that its European counterpart used to bail out its banks. The Journal speculated that the roundabout arrangement was followed in order to get around legal restrictions that prevented the ECB from lending to banks directly. The Journal called the arrangement “Byzantine” and questioned whether its design was simply meant to confuse the press and investors as to who was funding whom. In any event, the program seems to have achieved its end of keeping European banks solvent until the debt crisis had abated.

The Belgian head-scratcher may therefore be a simple case of central bank quid pro quo. In fact, on my radio program today, former Congressman Ron Paul shared my suspicions that there was indeed some type of “quid pro quo” coordination. While there is no smoking gun, the timing and scope of the buying is certainly suggestive of a coordinated effort. Confidence that the financial markets would stay stable during the tapering campaign was a critical element of the program's success. Any panic in the bond market would cause yields to spike, which would have a strong negative effect on stock prices and economic confidence. If the fear persisted for more than a few weeks, the Fed would have been forced to an embarrassingly early backtrack. The lost credibility would have greatly limited the Fed's latitude for further maneuver.

But what if the ECB started buying just as the Fed stopped? Better yet, what if the ECB purchases were larger than the taper? It would then appear that the Fed buying was simply a footnote in the current environment of ultra-low interest rates, not the driving force. It may not be coincidental that the Belgian buying began in earnest just as the tapering got underway. Something may in fact be rotten, and it’s not in Denmark…but several hundred kilometers to the southwest.

Rather than looking to explain the unusual spike in Belgian coffers, most market watchers are fixated by recent comments by Mario Draghi that the ECB is poised to launch a quantitative easing-style bond buying campaign in order to weaken the euro and to push up inflation in Europe. If that is the case, how long could the ECB be expected to fight a two-front monetary war…carrying water for the Fed while buying European bonds simultaneously? We must expect that any clandestine campaign by the Europeans to support Treasuries will have a brief shelf life, which could get even briefer if the ECB initiates their own QE.

It is a testament to the bovine nature of our financial media that this story is not being pursued strongly by all the power the fifth estate can muster. But who cares when rates are low and stock prices high? Have another chocolate. The Belgian ones are the best.

The following comes from an excellent article this week on the Motley Fool titled "Lessons From America's Greatest Investment Tragedy." It discusses the true value of holding cash, the one asset I consider the most hated and under owned today. I believe we are moving closer to a point in time when the true value of cash is going to reassert itself on the main stage of global finance.

Keep in mind what happened during this period. The Dow Jones fell 89% from 1929 to 1932, and unemployment shot to 25%. Those without enough cash to endure were forced to liquidate assets for pennies on the dollar. Then the market rose almost fivefold from 1932 to 1937 in the biggest five-year rally in history. Several blue-chip companies increased 10 or 20 times over. Those without cash (and guts) saw the greatest investment opportunity of their lives waltz right past them.

Roth was fascinated with the stock market, and how smart people could be destroyed by it. He repeats, over and over again, a simple investing lesson obvious to everyone who lived through the depression: the incredible value of having ample cash in the bank.

July, 1931: "Magazines and newspapers are full of articles telling people to buy stocks, real estate etc. at present bargain prices. They say that times are sure to get better and that many big fortunes have been built this way. The trouble is that nobody has any money."

Dec., 1931: "It is generally believed that good stocks and bonds can now be bought at very attractive prices. The difficulty is that nobody has the cash to buy."

July, 1933: "Again and again during this depression it is driven home to me that opportunity is a stern goddess who passes up those who are unprepared with liquid capital."

Keep in mind what happened during this period. The Dow Jones fell 89% from 1929 to 1932, and unemployment shot to 25%. Those without enough cash to endure were forced to liquidate assets for pennies on the dollar. Then the market rose almost fivefold from 1932 to 1937 in the biggest five-year rally in history. Several blue-chip companies increased 10 or 20 times over. Those without cash (and guts) saw the greatest investment opportunity of their lives waltz right past them.

This story repeats itself throughout history, just not as severe. During booms, all people care about is return, and complain about how worthless cash in the bank is, earning a puny yield. During a crash they realize that nothing is more precious than cash in the bank, even if you had to sit on it for years earning that puny yield.

We're doing this again today. So many are livid that their cash in the bank earns no more than 0.01%, losing money every day to inflation.

I think this is a terrible way to think about the value of cash, and it causes people to chronically underestimate its real worth. Cash doesn't earn much today, but it gives you options in the future.Over time, that potential can more than offset the dismal yield earned today.If earning 0.01% today allows you to become a financial vulture in a future market crash -- or avoid becoming a desperate seller -- then you're really earning far more than 0.01% on your cash today. It's hard to convince some people of this, because all they see is the advertised 0.01% return. But having options has real value. "Cash combined with courage in a crisis is priceless," Warren Buffet once said.

Faber see U.S. stocks as the most overpriced, Europe a little less, and some value showing in emerging markets. However, he says you have "time to wait" on buying into those markets because there is trouble ahead for asset prices in general.

Thursday, May 22, 2014

The major U.S. market indices have tracked sideways for most of 2014, which has been a stark difference from 2012 - 2013 when they seemed to rise continuously throughout both years.

While the major indices have stalled, some of the highest flyers of 2012 - 2013 (social media, biotech, etc) have crumbled. What has happened?

After investors move all-in with with their capital, the only option to continue buying stocks at overpriced valuations is to borrow money to buy more more. This is called "margin debt" in the world of Wall Street.

The chart below shows that margin debt hit a peak in February at $465.7 billion and has tracked downward for two consecutive months resting at $437.2 billion as of April. The important question is whether this is just another bump in the road toward higher levels of borrowed speculation or we have reached the next major peak in the mountains of speculation.

I was listening to an audio interview yesterday with one of my favorite writers, John Mauldin, who was discussing a major investment conference he held over the past week. He said that every year he asks the audience how likely a recession is over the next year. Three years ago almost everyone rose their hand but every year that number has fallen. This year no one raised their hand. He said that all his speakers at the conference were "cautiously bullish" but no one put a high likelihood of a recession occurring over the next year.

I find this fascinating at a time when the first quarter GDP growth was non-existent (some analysts believe the real data showed a decline), and many of the economic indicators (particularly housing) are flashing red.

The average recovery cycle lasts 39 months following a recession. We are currently in the sixth longest recovery in history, yet no one believes it is possible we could enter a recession in the next year. Market turns always catch the most possible people by surprise because at the turn the continued trajectory upward seems assured with months and months of recovery in your rear view mirror.

A better question would be to ask; if the investors in the first chart above that are currently all-in with maximum leverage believed there was a 20% chance of a recession in the next year, how would they re-act with their U.S. stock allocations? Of course, we will never know this answer because people move in herds. They believe everything is perfect right up until the very last moment, then run full sprint toward the exits in the burning building. This is why we see slow market rises over long periods during the recovery followed by waterfall declines during the panic sell-offs.

With the now infamous high frequency trading machines controlling the markets, the next panic sell-off should be unlike anything we have witnessed in history.

Wednesday, May 21, 2014

Technology is wonderful in the way it continuously reduces costs associated with everyday life. This new app called "Robinhood" will offer commission free trading for the average investor with just a few clicks of your phone. This will drastically reduce the current commission model in place for the large brokerage houses and will eventually bring it to zero across the board. CNN describes the store behind the new app here.

The number of underwater homes in the United States has fallen dramatically since early 2012 due to the recent bounce in prices. At the peak, 34.4% of all mortgages were underwater, and that percentage has dropped to 18.8% (still incredibly high).

10 million homeowners remain underwater and there are another 10 million that cannot cover the cost to sell (Realtor commissions, closing costs, etc). These 20 million hope and pray that the artificial bounce in home prices can continue before gravity once again takes hold of the market.

There was an interesting discussion with MISH on his site this week where he looked at the return on junk bonds compared to what you are risking to receive that return.

The average return (or annual interest payment) an investor receives by buying into the Barclays High Yield Bond Index is 5.85% (high yield is a nice way of saying "junk" or "high chance of default"). If you invest $100,000 in this index you can expect to receive $5,850 in annual interest payments.

BCA recently finished a study concluding it was time to invest heavily in this sector. They believe that the average default on these bonds will be 3.0% over the next year.

On top of this 3.0% loss there is the expected 2.0% loss that will occur due to inflation (you can argue that inflation is running far higher than that level when you look at real life costs of living but that is a topic for another day). This gives you a real return of:

5.85% - 3.0% (defaults) - 2.0% (inflation) = 0.85%

As of this writing you can currently invest in a 10 year U.S. treasury bond for about 2.5%. This is considered a risk free rate where your only loss category comes in the form of inflation.

2.5% - 2.0% (inflation) = 0.50%

The estimated return difference between the junk bonds and the risk free bonds is 0.35%. Is that worth running the risk that the economy could slow down just a tiny amount which would cause junk bond defaults to surge? See the default rates explode in 2008 in the chart above (it is the mountain on the left).

Investors do not think this way at the tail end of a debt fueled mania. The old saying goes that "a rolling debt gathers no loss." This means that as long as there is a greater fool available to roll the current debt into a new loan, everything looks great on the surface. When that next greater fool becomes a little nervous and decides to hold on to his liquidity then the game is up and junk bonds will implode.

This is part of the ebb and flow of a normal market cycle, and we are approaching the point where the tide will once again move out and the world will see who has been swimming naked.

The chart below shows gambling losses by country around the world. Gambling is a topic that fascinates me because it provides an excellent controlled environment to study the psychologically of the participants (information which can be directly correlated to the world's largest casino: the financial markets).

You can see in the graphic below that the United States leads the world in total losses. This would be an obvious conclusion considering they have the largest total amount of money to gamble, and the largest pile of money gambled always leads to the largest total losses.

The bars on the left provide a better look at the individuals that exist within those countries. It shows that Australia absorbs the highest level of losses per person, and they lose an enormous amount of that money at casinos and gaming machines. I always assumed that this title would be held by an Asian country where citizens are notorious for their love of gambling (Singapore is a close second).

"We should be careful to get out of an experience only the wisdom that is in it and stop there lest we be like the cat that sits down on a hot stove lid. She will never sit down on a hot stove lid again and but she will never sit down on a cold one either."

- Mark Twain

"It's waiting that helps you as an investor, and a lot of people just can't stand to wait."

- Charlie Munger

"Live as if you were to die tomorrow. Learn as if you were to live forever."

- Gandhi

"One of the best rules anybody can learn about investing is to do nothing, absolutely nothing, unless there is something to do. I just wait until there is money lying in the corner, and all I have to do is go over there and pick it up. I wait for a situation that is like the proverbial shooting fish in a barrel."

- Jim Rogers

"Capitalism without financial failure is not capitalism at all, but a kind of socialism for the rich."

- James Grant

"At this juncture, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained."

- Ben Bernanke, March 2007

"Everything that needs to be said has already been said. But since no one was listening, everything must be said again."

- Andre Gide

"When people are getting richer and richer but they're not actually producing anything, it can't end well."

- Louis CK

"In economics things take longer to happen than you think they will, and then they happen faster than you thought they could."

- Rudiger Dornbusch

"I don't write about what I know. I write to find out what I know."

- Patricia Hampl

"Chains of habit are too light to be felt until they are too heavy to be broken."

- Warren Buffett

"Everyone has a plan until they get punched in the mouth."

- Mike Tyson

"Interest on the debt grows without rain."

- Yiddish Proverb

"You can have comfort, or you can have value. You cannot have both."

- Jim Grant

"Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful."

- Warren Buffett

"No very deep knowledge of economics is usually needed for grasping the immediate effects of a measure; but the task of economics is to foretell the remoter effects, and so to allow us to avoid such acts as attempt to remedy a present ill by sowing the seeds of a much greater ill for the future."

- Ludwig von Mises

"Men who can both be right and sit tight are uncommon."

- Jesse Livermore

There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.

-Ludwig von Mises

"Most investors think quality, as opposed to price, is the determinant of whether something's risky. But high quality assets can be risky, and low quality assets can be safe. It's just a matter of the price paid for them."

- Howard Marks

"Whenever you find yourself on the side of the majority, it is time to pause and reflect."

-Mark Twain

"None are more hopelessly enslaved than those that falsely believe they are free."

-Goethe

"The longer the markets disobey basic rules of valuation, the bigger the opportunity for good investors to reap the benefits. Value investing works precisely because markets become dysfunctional at times."

-John Coumarianos

Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.

-Sir John Templeton

"No very deep knowledge of economics is usually needed for grasping the immediate effects of a measure; but the task of economics is to foretell the remoter effects, and so to allow us to avoid such acts as attempt to remedy a present ill by sowing the seeds of a much greater ill for the future."

- Ludwig von Mises

"People only accept change in necessity and see necessity only in crisis."

-Jean Monnet

Requiring a central bank to print money to increase government's purchasing power invariably ignites a hyperinflationary firestorm. The result through history has been toppled governments and severe threats to societal stability.

- Alan Greenspan

"It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning."

- Henry Ford

"Do you want to sell sugared water for the rest of your life? Or do you want to come with me and change the world?"

-Steve Jobs

"I'd be a bum on the street with a tin cup if the markets were always efficient."

-Warren Buffett

"The market can stay irrational longer than the investor can stay solvent."

- Keynes

"While the government struggles to save one crumbling enterprise at the expense of the crumbling of another, it accelerates the process of juggling debts, switching losses, piling loans on loans, mortgaging the future and the future's future. As things grow worse, the government protects itself not by contracting this process, but by expanding it."

-Ayn Rand, 1974

"The test of a first-rate intelligence is the ability to hold two opposing ideas in mind at the same time and still retain the ability to function."

- F. Scott Fitzgerald

"All our life, so far as it has definite form, is but a mass of habits - practical, emotional, and intellectual - systemically organized for our weal or woe, and bearing us irresistibly toward our destiny, whatever the latter may be."

-William James

"Men it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one."

-Charles Mackay

The greatest enemy of knowledge is not ignorance, it is the illusion of knowledge.

- Stephen Hawkings

"Give me control of a nations money supply, and I care not who makes it's laws."

- Amschel Rothchild

Illusions commend themselves to us because they save us pain and allow us to enjoy pleasure instead. We must therefore accept it without complaint when they sometimes collide with a bit of reality against which they are dashed to pieces.

- Sigmund Freud

Many of life's failures are people who did not realize how close they were to success when they gave up.